Quora Answer: Why Do Illiquid Portfolios Struggle When Markets Move Fast?

The following is my answer to a Quora question: “Why do long-term, bottom‑up investment portfolios that rely heavily on private equity and real assets often face performance slowdowns during periods of rapid market volatility?”

Private equity and real assets are designed for a world where capital is patient, prices are negotiated, and value is realised over years rather than minutes.  When markets move rapidly, that design becomes a liability.  Understanding why requires understanding what these asset classes actually are — and what assumptions underpin their performance during normal conditions.

The Valuation Lag Problem

Public market securities are marked to market continuously.  The price of a listed equity on a Tuesday afternoon is the price at which a willing buyer and a willing seller transact on a Tuesday afternoon.  It is observable, immediate, and indisputable.  Private equity is marked to model.  The valuation of an unlisted company in a private equity portfolio is determined by the fund manager’s internal assessment — typically a discounted cash flow analysis, a comparable company multiple, or a recent transaction reference — updated quarterly or semi-annually.  The valuation does not move in real time because there is no market in which real-time transactions occur.

During periods of rapid market volatility, this creates a specific and misleading dynamic.  The private equity portfolio appears stable — its reported NAV does not fall — while the public market comparables against which it is implicitly benchmarked are declining sharply.  The stability is not real.  It is a reporting artefact.  The underlying businesses are experiencing the same economic pressures as their listed peers.  The valuation simply has not caught up yet.

This phenomenon, known as return smoothing, produces the optical illusion of resilience during market downturns and inflated volatility measures during normal periods.  The private equity Sharpe ratio looks excellent because the denominator, volatility, is artificially suppressed by the lag in marking positions to reality.  When the fund manager eventually updates valuations to reflect the new economic environment, the write-downs appear in the quarterly report months after the market dislocation that caused them.  The investor who took comfort in the portfolio’s apparent stability during the volatility discovers, on a three to six-month delay, that the stability was a calendar artefact rather than a genuine economic outcome.

The Liquidity Mismatch

Private equity and real assets are, by construction, illiquid.  Capital committed to a private equity fund is locked for the fund’s life — typically ten to twelve years with limited extension options.  Real assets — infrastructure, timber, farmland, commercial real estate — cannot be sold in days without accepting a material discount to their appraised value.  During normal market conditions, this illiquidity is compensated by the illiquidity premium — the excess return that investors receive for accepting the constraint.  Academic research, including work by Dr. Ľuboš Pástor of the University of Chicago Booth School of Business, suggests the illiquidity premium for private equity has historically been approximately 3 to 5 percentage points above comparable public market returns on a risk-adjusted basis, though the evidence on whether this premium has persisted as the private equity asset class has grown is contested.

During periods of rapid market volatility, the illiquidity premium becomes an illiquidity penalty.  Consider the institutional investor whose portfolio allocation targets 60% public markets and 40% private and real assets.  A 25% decline in public market values — as occurred in the S&P 500 in 2022 — reduces the public market allocation’s absolute value while the private allocation's reported value remains stable.  The portfolio’s effective allocation to private assets has now risen to perhaps 50% — above the target — without any actual purchase of additional private assets.  This is the denominator effect, and it creates a specific problem.  The investor who needs to rebalance — returning to the 60/40 target — cannot sell private assets quickly or cheaply.  The only available lever is the public market portfolio, which means selling already-depressed liquid assets while being unable to reduce the inflated illiquid allocation.  The portfolio becomes progressively more concentrated in illiquid assets at precisely the moment when the investor needs flexibility.

The Softbank Vision Fund provides the most dramatic recent illustration of this dynamic.  At its peak, the fund had invested approximately US$100 billion across private technology companies — WeWork, Uber, DoorDash, and dozens of others — at valuations that reflected the zero-rate environment of 2019 to 2021.  When rates rose in 2022, and the public market comparables for these businesses fell sharply, Softbank’s reported NAV declined by approximately US$27 billion in a single quarter.  But the decline was only partially visible when it occurred.  The initial reported losses were smaller than the eventual write-downs because the private valuations were updated with a lag.  Softbank could not sell its positions at the previous valuations to manage the loss — the liquidity was not there.  It could not easily reduce its exposure because the assets were private.  The fund that had been celebrated for its visionary investments in private technology became the cautionary example of the illiquidity penalty at scale.

The Capital Call Problem

Private equity funds do not take capital up front.  They call capital as investment opportunities arise — typically over a three to five-year investment period.  The committed but uncalled capital sits with the investor, available to be deployed when the fund manager sends a capital call notice.  During periods of market volatility, capital calls arrive at precisely the wrong time.  The investor whose public market portfolio has just fallen 25% receives a capital call from the private equity fund that is actively deploying capital into the depressed market, which is, from a pure investment logic perspective, exactly when the fund should be deploying.  The investor must fund the capital call from a portfolio that is simultaneously under pressure.  This either requires selling public market positions at depressed prices to fund the call — locking in losses and reducing exposure at the bottom — or maintaining sufficient liquidity reserves to meet capital calls without forced selling.  The investor who did not maintain that liquidity reserve discovers its importance at the worst possible moment.

The 2008 financial crisis produced multiple documented instances of institutional investors — including endowments and pension funds — facing capital calls they could not easily fund.  Harvard University’s endowment — one of the most sophisticated institutional investors in the world — faced severe liquidity pressure in 2008-2009 precisely because of the mismatch between its illiquid private asset allocation and its liquidity requirements during the crisis.  The endowment reportedly had to issue bonds to fund its operating requirements because the illiquid portfolio could not be accessed.  Harvard borrowed money to meet its commitments because its investments were too illiquid to liquidate.

The lesson was not lost on institutional investors — but it has been repeatedly relearned by those who entered the private equity asset class during the subsequent decade of benign conditions and had not experienced the capital call pressure of a genuine liquidity crisis.

The Real Assets Specific Problem

Real assets — infrastructure, real estate, timber, farmland, commodities — face a distinct version of the same structural challenge, with additional sector-specific complications.  Infrastructure assets are long-duration, inflation-linked, and operationally stable.  Their valuation is highly sensitive to the discount rate applied to their long-term cash flows.  When interest rates rise rapidly — as they did globally in 2022 and 2023 — the present value of those future cash flows falls, even if the cash flows themselves are unchanged.  The asset that was valued at a 4% discount rate is worth considerably less at a 6% discount rate.  Infrastructure funds that marked their portfolios aggressively in the zero-rate environment faced material write-downs when the rate environment normalised.

Real estate is doubly exposed.  It faces the same discount rate sensitivity as infrastructure while simultaneously facing direct demand-side pressure during recessions — lower occupancy, lower rents, higher vacancy costs — that infrastructure does not typically experience.  The office real estate sector has demonstrated this with particular clarity in the post-COVID period: the combination of rising rates and structural demand reduction from hybrid working produced write-downs across major office portfolios that the pre-COVID valuations had not contemplated.

Blackstone’s Real Estate Income Trust — BREIT — provided the most visible institutional example.  BREIT imposed withdrawal limits on redemptions in late 2022 after redemption requests exceeded its quarterly limit of 2% of NAV.  The gate mechanism was contractually permitted and operationally rational — the underlying assets could not be liquidated fast enough to meet redemption requests without fire-sale pricing.  But the gate’s existence confirmed for investors what the theory had always held: real asset liquidity is conditional on market conditions, and the conditions under which you most want liquidity are precisely the conditions under which the gate is most likely to close.

The Bottom-Up Concentration Risk

Long-term, bottom-up portfolios — built on individual asset selection rather than top-down allocation — carry a specific concentration risk that amplifies the structural challenges above.  The bottom-up investor selects assets based on individual merits: the quality of the management team, the competitive position of the business, and the attractiveness of the specific real asset.  Over time, these individual selections accumulate into a portfolio whose sector, geographic, and factor exposures are the consequence of individual decisions rather than deliberate allocation.

During normal conditions, this is a feature.  The portfolio is not constrained by benchmark allocations or macro views that might override the individual asset quality assessment.  During rapid market volatility, it becomes a vulnerability.  The portfolio whose sector exposures were not deliberately managed may turn out to have significant concentration in sectors most affected by the volatility trigger — technology in 2022, office real estate post-COVID, energy in 2020 — without the top-down framework that would have prompted earlier attention to those concentrations.  The bottom-up investor discovers the portfolio’s factor exposures in the same way that other people discover their roof leaks: during the storm.

The Performance Slowdown Mechanism

The mechanics are now clear.  The valuation lag means the portfolio appears to perform better than its public market comparables during the initial phase of the volatility, but this is an illusion that resolves in subsequent reporting periods.  The eventual write-downs that capture the delayed mark-to-reality produce a performance slowdown that occurs after the public market has already partially recovered, giving the private portfolio the worst of both worlds: apparent stability followed by real losses, at a different point in the cycle from the public market recovery.

The liquidity mismatch means that the capital calls and distribution interruptions that occur during volatility create cash flow pressure at exactly the moment the investor least wants it — producing either forced selling of other assets or liquidity strain that constrains the investor's ability to take advantage of the depressed asset prices that the volatility creates.  The duration sensitivity of real assets means that rapid rate movements — the most common volatility trigger in recent cycles — hit real asset valuations directly through the discount rate channel, before any operational deterioration in the underlying assets is visible.

None of these is a design flaw.  They are the structural characteristics of illiquid, long-duration assets operating in a world that occasionally moves faster than their valuation frequency.  The investor who understands these mechanics can manage around them through adequate liquidity reserves, disciplined commitment pacing, and honest assessment of the reported NAV's relationship to realisable value.  The investor who does not understand them discovers them experientially.  The tuition fee is substantial.

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Terence Nunis | Executive Chairman, Equinox Zenith | Author, The 1% Playbook: The Billionaire Cheat Code